Priceless – Be Careful What You Wish For…

Ros Price, Investment Committee Member.

Following the Great Financial Crash of 2007/8 here in the UK, inflation first rose above the Bank of England’s 2% target as the economy struggled to come to grips with the calamity that had befallen it. Interest rates were slashed globally and unconventional monetary policies were introduced by central banks on a massive scale in an attempt to push economies into a bounce-back. Subsequently, inflation turned on its heels and fell to below zero in some countries, and to almost that in many more. So, a condition known as financial repression was set up in many Western economies; an environment where savers received next to nothing as their rate of return. This unfair outcome for those who had not borrowed to live beyond their means left many to hope for the return of significant inflation as a way of easing the real debt burden on borrowers, but for pension funds that must deliver an absolute return this is a nightmare scenario. The disinflation/deflation that accompanied the financial repression was not seen as a means of either retaining or even improving living standards although falling prices for many goods and services has meant many people could actually afford a better living standard than otherwise. In Japan for example where for several years’ disinflation and deflation persisted whilst interest rates were very low, the retired population suffered no erosion of their standard of living even though their savings were giving little or no return.

Falling prices and a fixed pension meant their living standards improved.

At a time when the US had become largely self-sufficient in oil, thanks to the fracking industry, Saudi Arabia decided to start a price war in a bid to force them to cut back on production. This saw the price of crude plummet to almost $20 a barrel causing a massive dent in the Saudi economy. A regime change following the death of the King, brought in a new oil minister who introduced a new policy on the pricing of crude oil and included non-OPEC producers such as Russia, who had also suffered economically from the low price.

So, inflation is back. Although this time rather than being caused by central banks pumping cheap money into their respective economies, it is due to OPEC restricting the supply of crude oil to the market (causing amazement to many by sticking to their promise). Thanks to rising oil prices and a strong US dollar, inflation in the EU and UK is just above the ECB’s and Bank of England’s respective targets. The so-called evil of disinflation has all but disappeared. This raises the question of how much inflation central bankers will tolerate before stepping in? We don’t need to look back too far to see the devastating effects that rising inflation can have. In the 1970s the wage-demand merry-go-round lead to the near collapse of the UK economy, while the winter of discontent brought Margaret Thatcher in to power. The UK endured mortgage interest rates of 15%! Those were not days to hanker after. We need to be sure that the Monetary Policy Committee at the Bank of England will have not only the power but also the nerve to ensure that we do not slide into such a predicament again. This will of course, become a political problem in the fairly near future, as even a little inflation hits those on lower incomes and fixed income hardest.

So, while a little ‘extra’ inflation removes some of the pain for a heavily indebted government by cutting the real value of that debt – how might it affect the rest of the economy? The man in the street does not of course purchase crude oil directly and may not really take on board its price rise impact. He may however, take account of its cost impact of around 5% on the consumer price basket in many developed countries (setting aside the impact of the 75% fall in the price of crude in recent years – remember the 99p/litre petrol price?) Now as the oil price rises, we can see just how far-reaching the impact such a price has. Prices of transport and some energy sources are the obvious rises but this also affects food costs, raw materials for plastics, fertilisers, paints, drugs and many other man-made compounds. The impact of increased transport and energy are already impacting spending and some service costs are rising too. In some countries, domestic labour costs are rising too, as workers demand to maintain the same standard of living that the previously lower costs had given them.

Of course, globally, different economies will have differing inflation parameters according to their economic structure. But one thing they have in common is: consumers who have to spend more on the oil related goods and services will have rather less to spend on other things, unless they can force employers to pay them more. Those without that power or who are not in the labour market, may well see their living standards decline if inflation rises quickly.

Obviously, the inflationary impact is not uniform, as different consumer groups have differing spending patterns and these vary too from country to country. Rates of inflation may be higher for different population groups as spending patterns differ, but inflation ‘inequality’ may become the next political hot potato. This is the year that we all need to adjust our expectations of the cost of living and the effects that rising inflation will have on consumers, on businesses and on markets. This return to an inflationary world will be complex too in its impact, with differing nuances as its impact affects differing groups of people. Economics will be even more politicised, if that is possible to imagine in the current febrile climate.

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IPS Capital LLP is a boutique, multi-asset investment manager that aims to provide consistent returns within a strong risk-controlled framework. An independently owned Partnership, IPS Capital was originally founded in 1999 as an investment adviser and consultant for UK pension funds.